If you’re planning on retiring soon, you likely are counting not only the days, but also the income that you’ve so carefully set aside for your golden years. You are not the only one: Uncle Sam has a stake in your retirement income as well – sometimes more, sometimes less, depending on the source.
If you don’t have a clear picture of your retirement income tax liability, NOW is the time to focus on it. You can also take specific steps now to reduce the amount of taxes you will owe in future years.
How to know what is taxable and what is not taxable?
I took this question to the professionals on the Hanscom Financial Services team and they agreed that, as a general rule, it’s a fairly straightforward formula: If you made after-tax contributions when you put retirement money into a plan, you shouldn’t owe taxes when you take the money out. If you made pre-tax contributions into a plan, you will owe taxes when withdrawing funds.
Five Common Sources of Taxable Income
Below you’ll find the five most common sources of taxable retirement income. To determine what your state taxes will be for each income source, check with the state in which you reside.
- Social Security
That money you paid into Social Security all those working years? It’s taxable for people who file more than $25,000 income on a single return, or $32,000 on a joint return. The percentage that is taxable depends on what’s known as “provisional income.” Provisional income is your adjusted gross income, plus tax-free interest, plus 50% of your benefits. Up to 85% of your Social Security benefits can be taxed. To figure out what you will owe, use the IRS Form SSA-1099.
- IRA and Other Pre-tax Retirement Plan Withdrawals
Whether or not your withdrawals from your company’s retirement plan (such as an IRA or 401K) will be taxed depends on the type of plan. Roth IRAs are not taxed after age 59 ½ AND 5 years. Otherwise you will be charged an early withdrawal penalty. Traditional IRAs, 401(k)s, and other plans that you paid pre-tax dollars into are taxed as regular income and are subject to penalties before 59 1/2.
Most private corporation and government pension payments are taxed as ordinary income, assuming that you did not contribute after-tax dollars into the pension plan. For example, the Thrift Savings Plan (TSP), a retirement plan for Federal employees and members of the uniformed services, operates much like a private company 401(k) plan. Any pretax dollars put into the plan are taxable upon withdrawal. Matching contributions by the government are also taxable upon withdrawal.
- Tax-deferred Annuity Withdrawals
Tax-deferred annuities may contain both a taxable and non-taxable portion: the taxable portion is any gain in the annuity, which must be withdrawn first. The gain is taxed as ordinary income; the principal amount is not taxed. Similar to other retirement plans, you would pay a penalty on any pre-tax contributions or gains taken out before 59 ½ years old.
- Investment Income
For qualified stock investments, dividend income is taxed at a special rate depending on what tax bracket you are in. For most stocks, you will be taxed at a lower rate than your ordinary income, giving you a tax break. Qualified dividends are dividends from stock that is publically traded. You will receive a 1099 form and pay taxes in the year they are earned.
Most bond income is taxed as ordinary income at the Federal level, except for municipal bonds, which are federal tax-free and can be state tax-free if they are from the state in which you reside. Corporate bonds are taxed at the federal, state, and local levels as ordinary income.
Non-taxable Retirement Income
The main source of tax-free income for retirees comes from any Roth IRA withdrawals. In addition, municipal bonds or municipal bond funds are tax-free, as opposed to corporate bond funds, which are taxable. Other sources of tax-free income are any after-tax contributions you made into a pension plan, the principal, or “cost” of any annuity you bought, and gains from the sale of your primary residence if you decide to sell.
These are just general guidelines to help you determine what types of retirement income are fully taxable, partially taxable, or tax free. Of course, the bottom line in your specific case can be best determined with the help of a financial professional.
More information about this topic can be found on the Hanscom Investment Services website.†
†Securities and advisory services are offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC). Insurance products are offered through LPL or its licensed affiliates. Hanscom Federal Credit Union is not registered as a broker-dealer or investment advisor. Registered representatives of LPL offer products and services using Hanscom Investment Services, and may also be employees of Hanscom Federal Credit Union. These products and services are being offered through LPL or its affiliates, which are separate entities from, and not affiliates of, Hanscom Federal Credit Union. Securities and insurance offered through LPL or its affiliates are:
Not Insured by NCUA or Any Other Government Agency / Not Hanscom Federal Credit Union Guaranteed / Not Hanscom Federal Credit Union Deposits or Obligations / May Lose Value